Mutual Appreciation – a rating agency conundrum

It’s easy to speculate that the rating agencies might not give a Mutual (or cooperative) insurer the credit they deserve in the rating process; that an agency may appear more familiar or comfortable with listed shareholder (stock) companies and that a shareholder company capital structure and profit mentality will drive better ratings. Is that really the case?

Deeper understanding of rating agency methodology suggests that the ratings outcome should not be inherently negatively influenced by a Mutual structure. Indeed among the world’s highest rated private sector insurers are the giant Mutuals State Farm from the US and Japan’s Zenkyoren.

Whilst it’s clear that these huge organisations, which have their histories in the agricultural sector, are unusual, it’s also apparent that, from a credit rating perspective, there are ‘pros and cons’ to both shareholder and policyholder ownership structures.

Nonetheless the perception exists among many Mutuals that they are bound to be disadvantaged. This article looks at why that is and what Mutuals can do to help themselves in the ratings process.

Communications with the agency

A first and important consideration is that listed shareholder companies inevitably have plenty of experience of presenting to equity (and sometimes debt) investors; Mutuals rarely have similar experiences. Indeed rating agency meetings and analyses may well be the most challenging that the management of a Mutual faces.

Human nature, being what it is, brings the danger that they might approach these meetings with a defensive demeanour; inherent discomfort; or maybe even dislike for the process. In these circumstances it’s all too easy to fall into the trap of believing that simply being a Mutual is enough; that the policyholder relationship should ‘do the job’.

Unfortunately, this will not work with the rating agencies. We lay out below some of the core potential strengths a Mutual may have from a credit rating point of view, but each of these has to be explained and justified to the agency in the specific context of an assessment of credit risk.

Strangely the reverse communication style can be a hindrance for shareholder companies when either –

They believe that rating agency analysts think like equity analysts and so give them a similar presentation,

and/or

They have well-resourced finance departments and believe that the team there should be capable of handling the ratings relationship; even though they rarely have any staff member with senior level rating agency experience.

Their meetings with the agency can therefore perhaps become too bullish in a ‘sales-y’ sense. But at least they are used to the analytical questioning and external examination.

In truth though, unless they have an internal resource with serious experience in working at rating agencies, both shareholder companies and Mutuals can struggle at times to understand the mind-sets of, and reactions from, the agency analysts.

Credit Rating Pros and Cons for Mutual vs Shareholder ownership

To begin with capital, the assessment of the current or prospective risk adjusted level of capital adequacy of a Mutual (even if the terminology might be different) is not fundamentally different from the assessment for a shareholder company.

Mutuals and shareholder companies can both have either diversified or specialist underwriting portfolios, which may or may not be in risky lines of business. Both may or may not seek to take meaningful investment risk. Attitudes to reserving may be very prudent, ‘best estimate’ or optimistic.

The key capital model factors are all therefore looked at on a case-specific basis irrespective of the ownership of the rated insurer.

The primary generic difference in capital analysis therefore is around what the agencies call ‘financial flexibility’.

To over-simplify the situation, rating agencies worry in particular about two things in this context– firstly the likelihood that ‘something’ might happen to cause a hole in an insurer’s balance sheet and secondly how that ‘hole’ might be filled.

For a shareholder company that’s often a question of how likely it seems that the prospect of future earnings (Return on Equity; RoE) would make it worthwhile for shareholders to replenish the lost capital; however the concept of ‘RoE’ is generally alien to a Mutual.

Nonetheless, two common features of Mutuals can compensate for this (or even provide greater comfort than is typical for a shareholder company).

Firstly there is the explicit or implicit ability to either retrospectively charge policyholders a supplement or raise future pricing. Both, of course, are highly predicated on the nature and strength of the Mutual/policyholder relationship (and therefore this should be a key focus in the rating agency discussions).

Secondly, precisely because they do not share the ‘maximise RoE’ pressure of shareholder companies, Mutuals may well carry more risk-adjusted capital in the first place as a ‘buffer’ for unexpected losses.

A more subtle concern however, is the long run maintenance of risk-adjusted capital through profit retention. While shareholder companies may be under shareholder pressure to maximise their returns, that usually goes along with a fundamental focus on sustainable absolute profitability. Assuming they succeed in that there is then an ongoing source of growth capital potentially available (retained profits). A Mutual however is generally seeking to maximise the affordability of cover for their members. Most will recognise the need for generating sufficient profit over time to both retain capital adequacy and provide the capacity for growth in coverage as their members need it; but absolute profitability is inevitably seen by the agencies as a secondary consideration for a Mutual.

Accordingly it is critical for a Mutual to demonstrate a planned process of how necessary, or desired, growth will be supported.

The strength of underwriting and/or investment risk management and governance is another critical area and one where the agencies will have different generic concerns for shareholder companies and Mutuals.

For the former this concern is all about the temptation for ‘jam today’; i.e. that the desire for rapid growth and increased market share leads to undue risk taking. Leadership incentive schemes, offensive or defensive M&A plans, or simply the desire for shareholder or media ‘salutation’ can all too easily create this temptation among a shareholder company’s leadership (as can a ‘roll the dice’ mentality if things have not been going well). Shareholder (or more accurately asset manager) rhetoric can also ramp up the pressure for the wrong kind of short-term growth.

The ‘mission’ of a Mutual should, logically, alleviate this kind of concern. Of course it would be naïve to assume Mutual leaderships don’t also sometimes care unduly about market share above performance, but fundamentally their role (in theory) makes taking a prudent, long-term view that much easier.

The potential agency concern for Mutuals is therefore more about having a sufficient performance focus per se, especially in underwriting. A 105% combined ratio can be seen as a perfectly acceptable target for a Mutual, but not if that tends to result in an actual 110% average outcome (even if the Mutual sees that ‘miss’ as being ‘covered’ by investment income). So, the critical rating issue for a Mutual in this context is to have, and to communicate, clear financial targets to the agency that are supportive of long term financial health and to be able to coherently explain why it will be able to achieve these.

So, does the perceived ratings difference actually exist?

When I worked at S&P, I undertook a comparison of the ratings of Mutuals and those of shareholder companies; nothing too detailed but simply to get a sense of what the difference was. I found that the average rating of Mutuals was marginally lower, but the range of ratings was also a lot narrower The reasoning? I guess I would identify the following generalisations –

Mutuals are, on average, smaller. Rating agencies are ‘size-ist’, to a degree – they take some comfort from size as it can offer some ‘clout’ in the market and also the hope that there is the possibility of some well-managed diversification.

Mutuals tend to operate in niches. This is another part of the diversification piece – by definition, you would expect one market to be more volatile than a collection of markets on average.

The specialist knowledge and long-term view of Mutuals somewhat offsets the two points above.

Fundamentally though, most Mutuals have a positive credit risk profile and one that in theory the rating agency criteria should positively reflect. However it is quite possible that Mutuals do not always communicate it well.